Audit value and charitable organizations

I examine whether donors favor charities that use high quality auditors and whether the propensity to donate varies directly with audit quality. I find that audit quality affects donor decisions in the market for contributions. From a signaling perspective, charities benefit simply from engaging a higher quality auditor. From an information perspective, donors are more sensitive to changes in reported accounting information verified by a high quality auditor. I also find that, after conditioning on the charity’s reputation, donors are still willing to give more to charities aligned with a quality auditor, but the effect of audit quality choice dissipates with the size of the charity. Thus, a charity’s reputation and the choice of auditor are substitute mechanisms for signaling the credibility of financial information to donors.     

“Surprise” material weakness disclosures: Effects on audit fees and audit report lags

Prior research shows that many of the companies that disclose material weaknesses in internal control (MWs) do not disclose such weaknesses in earlier quarterly 10-Q filings for the same year—i.e., the year-end MW disclosures are “surprise” disclosures. I first show, using data from 2009 to 2019, that such surprise MWs continue to be the majority of MW disclosures as late as 2019. I find that accelerated filer companies with surprise MWs pay lower fees compared to companies with no-surprise MWs; however, this finding does not hold for non-accelerated filers. I also find that there are no significant differences in the audit report lag of surprise and no-surprise MW disclosers. Thus, the lower audit fee paid by surprise MW disclosure companies may offer a possible explanation for the widespread prevalence of surprise MW disclosures. The results also highlight the importance of the external auditor in public disclosures of MWs. The findings have public policy relevance given the ongoing efforts to expand the set of companies that would be exempt from the auditor attestation of internal controls.     

Does Opinion Shopping Impair Auditor Independence and Audit Quality?

This study investigates how companies' threats to dismiss auditors and their engagement in opinion shopping influence auditor independence and audit quality, which in turn affect misstatements in financial statements. It also examines how outsiders' reactions to auditor switching influence opinion shopping. The results indicate that neither the predecessor auditor's nor the successor auditor's independence is compromised by dismissal threats and opinion shopping. Further, the successor auditor's audit quality exceeds the predecessor auditor's audit quality. In addition, auditor switching decreases potential understatements and increases potential overstatements in financial statements, and the capital market's and the successor auditor's reactions to auditor switching reduce the benefits of opinion shopping to companies. Additionally, the study sheds some light on the potential effects of both the Sarbanes‐Oxley's restriction on non‐audit services and mandatory auditor rotation or retention. The paper also derives a rich set of empirical implications.     

Pro forma disclosures,audit fees,and auditor resignations

The disclosure of non-GAAP (pro forma) earnings numbers by managers in the post-SOX era continues to attract attention from regulators, media, and researchers. However, there is limited empirical evidence on how auditors view clients that emphasize pro forma earnings over GAAP earnings. We study the extent to which audit fees and auditor resignations are associated with opportunistic non-GAAP disclosures. We find that during the pre-SOX period, optimistic pro forma differences, measured using either IBES actual earnings or hand-collected pro forma earnings, are associated with higher audit fees and a higher likelihood of auditor resignations. Additional results indicate that auditors seem to be more concerned with non-GAAP earnings disclosures in the post-SOX period.     

Public and private sector auditors and accruals quality in English NHS hospital Trusts

To promote auditor independence and audit quality in English NHS Trusts the Audit Commission regulates auditor rotation, fees and the appointment of its own and private sector auditors. NHS sanctioned departures from GAAP, some of which allow the financial breakeven target to be achieved, have been criticised by the Audit Commission as detrimental to financial discipline. In this paper, we investigate the association between abnormal accruals and the achievement of financial breakeven in NHS hospital Trusts over the period 1998–2005. We also investigate the association between abnormal accruals, audit fees and the Trusts audited by public and private sector auditors. We find evidence that abnormal accruals are used to achieve financial breakeven and they differ across different types of auditor. We also identify a negative relationship between abnormal accruals and NHS Trust star ratings. These findings raise questions about the ‘quality’ of NHS audit where compliance with NHS-specific regulations overrides the wider GAAP-based requirement for financial statements to show a true and fair view and they warrant reconsideration of the nature of audit in NHS Trusts.     

Audit Firm Industry Specialization and Client Disclosure Quality

This paper provides evidence that clients select auditors as part of their overall disclosure strategy. We hypothesize that in addition to higher quality audits, industry-specialist audit firms assist clients in enhancing disclosures. We also posit that the choice of an industry-specialist auditor signals a clients intention to provide enhanced disclosures. However, we predict that industry-specialist audit firms are less important in regulated industries where enhanced disclosures add little value. Consistent with our hypotheses, we document a positive association between industry-specialist audit firms and analysts rankings of disclosure quality in unregulated industries, but no relation in regulated industries.     

Changes in audit effort and changes in auditors’ disclosures of risks of material misstatement

This paper investigates whether auditors' year-to-year modification to risks of material misstatements (RMMs) in extended auditors' reports (EARs) are associated with changes in underlying audit effort, as proxied by changes in audit fees. We examine the dynamics of RMMs over time in terms of adding or dropping specific RMMs. Our main results show that, on average, audit fees increase more from the previous year's fees when more RMMs are added to the current year's EAR. This increase is partially offset by dropping RMMs that were disclosed in the previous year, but changes in audit fees are not significantly affected by dropping RMMs without adding new RMMs. Further analysis suggests the effect of added RMMs is attributable to “new” RMMs originating with the auditor and that added RMMs that were previously known, based on related disclosures in the prior year's audit committee report, do not significantly impact on changes in audit fees. Overall, our results suggest that changes in the choice of RMMs included in EARs reflect changes in underlying audit effort.     

The association between employee stock option disclosures and corporate governance: Evidence from an enhanced disclosure regime

This study examines the role of corporate governance in employee stock option (ESO) disclosures following the revision of AASB 1028 Employee Benefits in 2001. We find that, while firms do not fully comply with AASB 1028 ESO disclosures, they voluntarily provide other ESO disclosures. In relation to corporate governance measures that have a role in the financial reporting process, we find two corporate governance measures dominate our results—the quality of auditor and duality of the role of CEO and Chair of the Board of Directors. We show that, in general, external auditor quality has positive incremental association with both mandatory and voluntary ESO disclosures while the dual role of CEO and chairperson of the board is associated with lower levels of mandatory disclosure.     

Opaque auditor dismissal disclosures: What does timing reveal that disclosures do not?

Auditor resignations provide a clear signal of accounting problems or heightened audit risk; however, registrants label the vast majority of auditor changes as dismissals, which carry more ambiguity. Motivated by the opacity of current dismissal disclosures, this study explores the usefulness of these disclosures compared to an alternative signal – the timing of the dismissal within the reporting year – for inferring the causes and implications of dismissals. Dividing the reporting year into key periods, we find that the probabilities of future restatements, material weaknesses, and delistings following a dismissal generally increase within the reporting year while negative circumstances disclosed do not. Analyses suggest that the timing patterns are caused by burgeoning, yet undisclosed, conflicts between the client and the outgoing auditor, rather than by transition difficulties involving the new auditor (as prior literature claims). The timing patterns strongly persist after controlling for negative circumstances that registrants disclose in the dismissal filing, suggesting that the disclosures are not fully revealing. In fact, disclosed negative circumstances have no incremental predictive power for future restatements and delistings. Our results suggest a severe lack of informativeness of current disclosures and support previous calls for improvement of dismissal disclosure regulation.     

Costs and benefits of auditors' disclosure of critical audit matters: Initial evidence from the United States

In an effort to make audit reports more informative to financial statement users, the Public Company Accounting Oversight Board (PCAOB) requires an expanded audit report in which auditors are required to disclose critical audit matters (CAMs). The new standard (AS 3101) became effective for audits of financial statements of large accelerated filers for fiscal years ending on or after June 30, 2019. Using a sample of annual reports of large accelerated filers with and without CAM disclosures, we examine the costs and benefits of the mandatory disclosure of CAMs in auditors' reports. Our evidence suggests that compared to auditor reports reporting no CAMs, the presence of a single CAM disclosure in the auditor's report provides incremental information to equity investors without a significant increase in audit costs. However, using the benchmark of a single CAM disclosure, multiple CAMs in an auditor's report results in higher audit fees and longer audit delays.     

The impact of corporate governance on auditor choice: Evidence from China

As the largest and fastest growing emerging market, China is becoming more and more important to investors throughout the world. The purpose of this paper is to investigate the determinants of firms’ auditor choice in China in respect of their corporate governance mechanism. Normally firms have to take a trade-off in their auditor choice decisions, i.e., to hire high-quality auditors to signal effective audit monitoring and good corporate governance to lower their capital raising costs, or to select low-quality auditors with less effective audit monitoring in order to reap private benefits derived from weak corporate governance and less-transparent disclosure (the opaqueness gains). We develop a logit regression model to test the impact of firms’ internal corporate governance mechanism on auditor choice decisions made by IPO firms getting listed during a bear market period of 2001–2004 in China. Three variables are used to proxy for firms’ internal corporate governance mechanism, i.e., the ownership concentration, the size of the supervisory board (SB), and the duality of CEO and chairman of board of directors (BoDs). We classify all auditors in China into large auditors (Top 10) and others (non-Top 10), assuming the large auditors can provide higher quality audit services. The empirical results show that firms with larger controlling shareholders, with smaller size of SB, or in which CEO and BoDs chairman are the same person, are less likely to hire a Top 10 (high-quality) auditor. This suggests that when benefits from lowering capital raising costs are trivial, firms with weaker internal corporate governance mechanism are inclined to choose a low-quality auditor so as to capture and sustain their opaqueness gains. On the other hand, with improvement of corporate governance, firms should be more likely to appoint high-quality auditors.     

Disclosure of fair value measurement in goodwill impairment test and audit fees

Recent increases in the occurrence and magnitude of goodwill impairment charges highlight the increasing importance of the role of the auditor in goodwill accounting. This study examines the association between disclosures about the fair value measurement of goodwill and audit fees. We find that goodwill-related disclosures are positively related to audit fees, consistent with the idea that auditors increase their audit efforts to mitigate potential reputational and litigation losses (“audit risk effect”). Additionally, our results indicate that the information asymmetry and investor scrutiny moderate the association between goodwill-related disclosures and audit fees. One possible explanation is that auditors take goodwill-related disclosures as a signal of truthful goodwill accounting and this “signaling effect” partially offsets the “audit risk effect” of goodwill-related disclosures when information asymmetry or investor scrutiny is perceived as high.     

The impact of auditor rotation on auditor–client negotiation

This paper reports the results of an experiment designed to investigate how mandatory audit firm rotation affects auditor–client negotiations. Drawing upon process theories of negotiation, we examine the strategies used by auditors and clients as well as the outcomes of their negotiations in alternative settings in which mandatory rotation is imposed or is not imposed. We posit that mandatory rotation changes (1) the dynamics of the audit market by increasing the number of clients who are in the market for a new auditor, and (2) the political costs to a client who switches auditors. These changes, in turn, alter the willingness of the auditor and the client to cooperate during negotiation. The results suggest that with mandatory rotation auditors adopt less cooperative negotiation strategies, producing asset values that are more in line with the auditor’s preferences than with the client’s preferences and more negotiation impasses.     

Group audits: Are audit quality and price associated with the Lead auditor’s decision to accept responsibility?

Lead auditors frequently rely on work performed by Other auditors, especially when auditing clients with operations in multiple countries. The PCAOB has expressed concern that the quality of such group audits may differ depending on whether the Lead auditor accepts or declines responsibility for work done by Other auditors. The PCAOB also has been concerned with the venue through which Lead auditors and Other auditors disclose their participation in group audits, including disclosure of whether Lead auditors accept or decline responsibility. To investigate these issues, we employ a sample consisting entirely of group audit engagements. We identify Lead auditors taking responsibility from PCAOB Form 2, filed by Other auditors of U.S. registrants for fiscal years 2009 to 2017. We identify Lead auditors not accepting responsibility from audit report disclosures during the same period. The results suggest that Lead auditors accepting responsibility charge higher audit fees but provide audits of no higher quality, and possibly of even lower quality. These results are robust to various additional analyses. Our research contributes to the ongoing debate over how the participation of Other auditors affects audit quality.     

What do we know about audit quality?

This paper reviews empirical research over the past 25 years, mainly from the United States, in order to assess what we currently know about audit quality with respect to publicly listed companies. The evidence indicates that outright audit failure rates are infrequent, far less than 1% annually, and audit fees are quite small, less than 0.1% of aggregate client sales. This suggests there may be an acceptable level of audit quality at a relatively low cost. There is also evidence of voluntary differential audit quality (above the legal minimum) along a number of dimensions such as firm size, industry specialization, office characteristics, and cross-country differences in legal systems and auditor liability exposure. The evidence is very positive although there is some indication that audit quality may have declined in the 1990s, in which case there could be merit in recent reforms such as the Sarbanes-Oxley Act of 2002 in the US. However, we do not know from research the optimal level of audit quality and therefore whether we currently have ‘too little’ or ‘too much’ auditing? Despite this lacuna we are entering an era of more mandated auditing in response to high-profile corporate governance failures including the Enron–Andersen affair. Finally, while recent reforms have scaled back the scope of non-audit services due to independence concerns, a case can be made that audit quality will always be somewhat suspect if other services are provided that are perceived to potentially compromise the auditor's objectivity and skepticism. For this reason public confidence in audit quality may be increased by proscribing all non-audit services for audit clients. Recommendations are also proposed with respect to legal liability reform and changes in partner compensation arrangements.     

Adoption and content of key audit matters and stock price crash risk

We examine whether the mandate for auditors to report key audit matters (KAMs) affects firm-specific stock price crash risk in China. Auditors in China are required to issue an expanded audit report that contains KAMs for AH-share firms, effective on January 1, 2017 (applicable to the financial year 2016), and for A-share firms, effective on January 1, 2018 (applicable to the financial year 2017). Applying a staggered difference-in-differences (D-i-D) design on a sample of 18,751 observations for financial years 2012–2019, we find that auditor reporting of KAMs is not significantly associated with stock price crash risk. The mechanism tests show that the disclosure of KAMs does not reduce information opaqueness and managerial opportunistic behaviors. Furthermore, our findings are not sensitive, but are robust to firms' corporate governance, product market competition, ownership structure, and auditor size. Overall, our study informs regulators, investors, auditors, and other stakeholders interested in the economic consequences of mandating KAM disclosures.     

How do auditors view managers’ voluntary disclosure strategy? The effect of earnings guidance on audit fees

The objective of this study is to examine the relation between attributes of earnings forecasts issued by managers and audit fees. Although there is an extensive literature on managers’ disclosure of earnings forecasts, there is a paucity of research on how auditors incorporate information from these voluntary disclosures. We find that the issuance of an annual or quarterly management earnings forecast in the prior period is positively associated with the current period audit fees. Our results indicate that on average, audit fees are higher by about 7% for firm-years associated with an annual forecast. Among the firms that issue earnings forecasts, we find no association between audit fees and likelihood of updating a previously issued earnings forecast, indicating that auditors do not view such behavior negatively. Further, we find audit fees to be positively associated with the error and the bias (or optimism) in the forecasts for annual forecasts but not for quarterly forecasts. Overall, these results suggest that management’s forecast behavior captures higher business risk for the auditor via greater risk of earnings management or litigation risk.     

Do seasoned industry specialists provide higher audit quality? A re-examination

The purpose of this paper is to re-examine the recent findings in Gaver and Utke (2019) (GU) who find that seasoned industry specialist auditors provide higher audit quality. We first illustrate how the magnitude of residuals from the accruals model can vary significantly by industry, thus highlighting the importance of including industry fixed effects when the dependent variable is discretionary accruals. We next replicate GU’s findings. We first attempt to replicate prior literature after including industry fixed effects in the audit quality (discretionary accruals) models. This is an important control, as the relevant benchmark for a firm with an industry specialist auditor is a peer firm in the same industry with a non-specialist auditor. We find that after including industry fixed effects, there is no association between seasoned industry specialist auditors and discretionary accruals. We also find that the association between industry specialization and discretionary accruals is very sensitive to the way in which the researcher calculates specialization. Our findings are informative for shareholders of public companies who vote on auditor ratification.